CORPORATE FINANCE ASSIGNMENT

ON

Role OF FINANCIAL SERVICES IN ECONOMIC DEVELOPMENT OF A COUNTRY

S. No Contents Page No.1 Introduction to Financial Services 2-42 Role of Financial Services in Economic Development 5

3 Innovations in Financial Services and Their Role in Economic Development

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4 References 8

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Submitted To: Dr. Anju Singla

Submitted By: Abhishek Taluja

SID: 11107003

B.E. Mechanical

INTRODUCTION TO FINANCIAL SERVICES

Financial services may be defined as the products and services offered by financial institutions for the facilitation of various financial transactions and other related activities. Financial services refer to services provided by the finance industry. The finance industryconsists of a broad range of organisations that deal with the management of money. Theseorganisations include banks, credit card companies, insurance companies, consumer financecompanies, stock brokers, investment funds and some government sponsored enterprises.

Scope of Financial Services [1]

The scope of financial services is very wide. This is because it covers a wide range of services. The financial services can be broadly classified into two: (a) fund based services and (b) non-fund services (or fee-based services)

A. Asset/Fund Based Services

1. Equipment leasing/Lease financing: A lease is an agreement under which a firm acquires a right to make use of a capital asset like machinery etc. on payment of an agreed fee called lease rentals. The person (or the company) which acquires the right is known as lessee. He does not get the ownership of the asset. He acquires only the right to use the asset. The person (or the company) who gives the right is known as lessor.

2. Hire purchase and consumer credit: Hire purchase is an alternative to leasing. Hire purchase is a transaction where goods are purchased and sold on the condition that payment is made in instalments. The buyer gets only possession of goods. He does not get ownership. He gets ownership only after the payment of the last instalment. If the buyer fails to pay anyinstallment, the seller can repossess the goods. Each instalment includes interest also.

3. Bill discounting: Discounting of bill is an attractive fund based financial service provided by the finance companies. In the case of time bill (payable after a specified period), the holder need not wait till maturity or due date. If he is in need of money, he can discount the bill with his banker. After deducting a certain amount (discount), the banker credits the net amount in the customer’s account. Thus, the bank purchases the bill and credits the customer’s account with the amount of the bill less discount. On the due date, the drawee makes payment to the banker. If he fails to make payment, the banker will recover the amount from the customer who has discounted the bill. In short, discounting of bill means giving loans on the basis of the security of a bill of exchange.

4. Venture capital: Venture capital simply refers to capital which is available for financing the new business ventures. It involves lending finance to the growing companies. It is the investment in a highly risky project with the objective of earning a high rate of return. In short, venture capital means long term risk capital in the form of equity finance.

5. Housing finance: Housing finance simply refers to providing finance for house building. It emerged as a fund based financial service in India with the establishment of National Housing Bank (NHB) by the RBI in 1988. It is an apex housing finance institution in the country. Till now, a number of specialised financial institutions/companies have entered in the filed of housing finance. Some of the institutions are HDFC, LIC Housing Finance, Citi Home, Ind Bank Housing etc.

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6. Insurance services: Insurance is a contract between two parties. One party is the insured and the other party is the insurer. Insured is the person whose life or property is insured with the insurer. That is, the person whose risk is insured is called insured. Insurer is the insurance company to whom risk is transferred by the insured. That is, the person who insures the risk of insured is called insurer. Thus insurance is a contract between insurer and insured. It is a contract in which the insurance company undertakes to indemnify the insured on the happening of certain event for a payment of consideration. It is a contract between the insurer and insured under which the insurer undertakes to compensate the insured for the loss arising from the risk insured against.

7. Factoring: Factoring is an arrangement under which the factor purchases the accountReceivables (arising out of credit sale of goods/services) and makes immediate cash payment to the supplier or creditor. Thus, it is an arrangement in which the account receivables of a firm (client) are purchased by a financial institution or banker. Thus, the factor provides finance to the client (supplier) in respect of account receivables. The factor undertakes the responsibility of collecting the account receivables. The financial institution (factor) undertakes the risk. For this type of service as well as for the interest, the factor charges a fee for the intervening period. This fee or charge is called factorage.

8. Forfaiting: Forfaiting is a form of financing of receivables relating to international trade. It is a non-recourse purchase by a banker or any other financial institution of receivables arising from export of goods and services. The exporter surrenders his right to the forfaiter to receive future payment from the buyer to whom goods have been supplied. Forfaiting is a technique that helps the exporter sells his goods on credit and yet receives the cash well before the due date. In short, forfaiting is a technique by which a forfaitor (financing agency) discounts an export bill and pay ready cash to the exporter. The exporter need not bother about collection of export bill. He can just concentrate on export trade.

9. Mutual fund: Mutual funds are financial intermediaries which mobilise savings from thepeople and invest them in a mix of corporate and government securities. The mutual fund operators actively manage this portfolio of securities and earn income through dividend, interest and capital gains. The incomes are eventually passed on to mutual fund shareholders.

Non-Fund Based/Fee Based Financial Services1. Merchant banking: Merchant banking is basically a service banking, concerned withproviding non-fund based services of arranging funds rather than providing them. The merchant banker merely acts as an intermediary. Its main job is to transfer capital from those who own it to those who need it. Today, merchant banker acts as an institution which understands the requirements of the promoters on the one hand and financial institutions, banks, stock exchange and money markets on the other. SEBI (Merchant Bankers) Rule, 1992 has defined a merchant banker as, “any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities or acting as manager, consultant, advisor, or rendering corporate advisory services in relation to such issue management”.

2. Credit rating: Credit rating means giving an expert opinion by a rating agency on the relative willingness and ability of the issuer of a debt instrument to meet the financial obligations in time and in full. It measures the relative risk of an issuer’s ability and willingness to repay both interest and principal over the period of the rated instrument. It is a

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judgement about a firm’s financial and business prospects. In short, credit rating means assessing the creditworthiness of a company by an independent organisation.

3. Stock broking: Now stock broking has emerged as a professional advisory service. Stockbroker is a member of a recognized stock exchange. He buys, sells, or deals in shares/securities. It is compulsory for each stock broker to get himself/herself registered with SEBI in order to act as a broker. As a member of a stock exchange, he will have to abide by its rules, regulations and bylaws.

4. Custodial services: In simple words, the services provided by a custodian are known ascustodial services (custodian services). Custodian is an institution or a person who is handed over securities by the security owners for safe custody. Custodian is a caretaker of a public property or securities. Custodians are intermediaries between companies and clients (i.e. security holders) and institutions (financial institutions and mutual funds). There is an arrangement and agreement between custodian and real owners of securities or properties to act as custodians of those who hand over it. The duty of a custodian is to keep the securities or documents under safe custody. The work of custodian is very risky and costly in nature. For rendering these services, he gets a remuneration called custodial charges.Thus custodial service is the service of keeping the securities safe for and on behalf of somebody else for a remuneration called custodial charges.

5. Loan syndication: Loan syndication is an arrangement where a group of banks participate to provide funds for a single loan. In a loan syndication, a group of banks comprising 10 to 30 banks participate to provide funds wherein one of the banks is the lead manager. This lead bank is decided by the corporate enterprises, depending on confidence in the lead manager.A single bank cannot give a huge loan. Hence a number of banks join together and form asyndicate. This is known as loan syndication. Thus, loan syndication is very similar to consortium financing.

6. Securitisation (of debt): Loans given to customers are assets for the bank. They are calledloan assets. Unlike investment assets, loan assets are not tradable and transferable. Thus loan assets are not liquid. The problem is how to make the loan of a bank liquid. This problem can be solved by transforming the loans into marketable securities. Now loans become liquid. They get the characteristic of marketability. This is done through the process of securitization. Securitisation is a financial innovation. It is conversion of existing or future cash flows into marketable securities that can be sold to investors. It is the process by which financial assets such as loan receivables, credit card balances, hire purchase debtors, lease receivables, trade debtors etc. are transformed into securities. Thus, any asset with predictable cash flows can be securitised. Securitisation is defined as a process of transformation of illiquid asset into security which may be traded later in the opening market. In short, securitization is the transformation of illiquid, non- marketable assets into securities which are liquid and marketable assets. It is a process of transformation of assets of a lending institution into negotiable instruments. Securitisation is different from factoring. Factoring involves transfer of debts without transforming debts into marketable securities. But securitisation always involves transformation of illiquid assets into liquid assets that can be sold to investors.

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ROLE OF FINANCIAL SERVICES IN ECONOMIC DEVELOPMENT

Financial services are fundamental to economic growth and development. Banking, savings and investment, insurance, and debt and equity financing help private citizens save money, guard against uncertainty, and build credit, while enabling businesses to start up, expand, increase efficiency, and compete in local and international markets. For the poor, these services reduce vulnerability and enable people to manage the assets available to them in ways that generate income and options — ultimately creating paths out of poverty. The financial services sector is the largest in the world in terms of earnings, comprised of a wide range of businesses including merchant banks, credit card companies, stock brokerages, and insurance companies, among others. It focuses primarily on large domestic and multinational commercial banks. These large firms have the expertise, reputation, and geographic reach to have significant direct impact and, through engagement and example, to change the way entire markets operate. They are using increasingly deliberate strategies to expand economic opportunity through business models that serve poor individuals and SMEs as clients. They are also developing initiatives to build human and institutional capacity and using their experience and influence to shape policy frameworks in the regions in which they work.

The following data shows that countries with large proportion of population excluded from the formal financial system also have higher poverty ratios and higher inequality[2]

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Here, Gini Index measures the extent to which the distribution of income or consumption expenditure among individuals within an economy deviates from a perfectly equal distribution.

INNOVATIONS IN FINANCIAL SERVICES AND THEIR ROLE IN ECONOMIC DEVELOPMENT [3]

Financial services firms have traditionally paid little attention to the poor because, by definition, the poor have limited assets. Informality, insufficient information, inadequate infrastructure and other barriers have reinforced the belief that serving the poor cannot be commercially viable, much less a driver of innovation. New, lower-cost business models (new financial services) have begun to challenge this conclusion, relying for instance on innovations in technology and utilization of existing retail channels.

1. MICRO CREDIT - Nearly all multinational commercial banks are now involved in microfinance in some capacity. Most do not provide micro-credit directly to clients, but rather invest in or structure deals on behalf of established microfinance institutions. For example, Deutsche Bank, in collaboration with the US Agency for International Development (USAID), the UK's Department for International Development (DFID), and a group of philanthropists and socially responsible investors, has created a new investment facility called the Global Commercial Microfinance Consortium. The Consortium leverages participating donors as the first bearers of risk to generate investment from commercial investors; so far demand has exceeded expectations. Microfinance plays vital role in economic development through following ways:

Poverty alleviation - It has been found an effective tool for lifting the poor by providing them financial services to start or expand a small business that enables them to earn an income so they no longer have to struggle to afford food, clean water, healthcare and education for their children.

Women Empowerment - Poor women use small loans to start a long chain of economic activity and raise their socio-economic status in the society.

Financial Inclusion - Microfinance has been recognized as an important tool in connectivity the unbanked population to mainstream institutional banking services. It has contributed to reduce their dependency on informal money lenders and non-institutional sources.

Mobilization of Savings - Microfinance develops the saving habits among the people. Now poor people with meager income also save money and are bankable. The financial resources generated through saving of group members and micro credit obtained from banks is utilized to provide loans to its members.

Development of Skills - Microfinance has helped in identifying the potential rural entrepreneurs. SHGs encourage its members to set up their businesses jointly or individually. They receive training from their supporting institutions and learn leadership qualities. Thus, microfinance helps indirectly in the development of skills.

2. MICRO SAVINGS - While the poor are often precluded from opening traditional bank accounts due to high transaction fees, required deposit minimums, and the physical distance between the client and the bank, the poor still find ways to save, often through traditional networks and institutions. Recently, to promote micro-savings a scheme Jan Dhan Yojana has been launched in India in which every Indian family will be enrolled in a bank for opening a zero balance account.

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3. REMITTANCES - Remittance flows are large and rapidly growing. A number of major financial institutions have begun to offer remittance products that generate new revenue directly and also help increase the number of personal banking accounts. In the US, for example, Citibank is offering low fee accounts to immigrants from Mexico, enabling them to send remittances that relatives at home can access via its Mexican subsidiary, Banamex, using only a card. Citi is also offering Ecuadorian clients in the US remittances of up to $3,000 for only $5, delivered through microfinance organization Banco Solidario in Ecuador.

4. SME FINANCE - Though to date it has been overshadowed by microfinance, SME finance is critical in helping entrepreneurs and small businesses reach sizes where it is possible to take advantage of economies of scale and create jobs in significant numbers. To date, much of the innovation has been outside the commercial banking sector. In South Africa, for instance, Anglo Zimele makes debt and equity investments in small and medium black economic empowerment (BEE) enterprises connected with the mining industry, sometimes facilitating linkages between its portfolio companies and its parent Anglo American. With support from the Shell Foundation, GroFin, a pan-African investment firm, provides debt and equity along with business development services to SMEs in South Africa, Kenya, Uganda, Tanzania, Rwanda, and Nigeria.

5. INSURANCE - The poor operate on razor-thin margins, and without significant savings, insurance, or government "social safety nets" to rely on, they are extremely financially vulnerable. In India, ICICI Lombard Insurance has teamed up with the microfinance institution BASIX to provide crop insurance for rain-fed farmers. Payments are made if rain falls below a certain amount, or if certain other weather patterns occur; this weather-indexed model has eliminated much of the cost associated with indemnity-based insurance. ICICI Lombard projects that the business, first piloted in 2003, will become profitable by the end of 2008.

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REFERENCES

[1] Study Material by Sri. Praveen M V, Asst. Professor , Dept. of Commerce ,Govt. College, Madappally.

[2] Text of the “Independence Commemoration Lecture, 2008” by Ms Usha Thorat,

Deputy Governor of the Reserve Bank of India, at the Central Bank of Sri Lanka, Colombo, 28 February 2008.

World Bank (2006), World Development Indicators, Washington.

World Bank (2008), Finance for All - Policies and Pitfalls in Expanding Access; Washington.

[3]

Banerjee, A., and A. Newman. 1993. ―Occupational Choice and the Process of Development.‖ Journal of Political Economy 101 (2):274–98.

Beck, T. R. Levine, and N. Loayza, 2000. ―Finance and the Sources of Growth.‖ Journal of Financial Economics 58(1–2):261–300.

Miller, M. 1988. ―Financial Markets and Economic Growth.‖ Journal of Applied Corporate Finance

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